11 March 2017

John Nugée: Central banking: edging closer to normality

Last Thursday, Mario Draghi, the president of the European Central Bank, said that while the ECB’s interest rates would stay unchanged, there was “no longer a sense of urgency for taking further actions” on monetary stimulus, and later this week the US Federal Reserve is almost universally expected to raise its official interest rates.

Nor, unlike in 2015 and 2016, is the Fed likely this year to be “one and done” – in both the last two years, the first increase in Fed Funds rate was also the last of the year, but this year most market commentators are pencilling in at least one and possibly two further rises after Wednesday’s expected hike.

But if interest rate rises are well and truly back on the agenda in much of the G7, another consequence of the unorthodox policies of recent years is still very much with us.  Central bank balance sheets remain very large indeed – well over 20% of GDP for the Fed, the ECB and the Bank of England and very much more than that for the Bank of Japan.  And there are few signs that this is about to change any time soon.

[...]the desire to end the experiment of QE is felt keenly, partly because of the natural wish to be able to declare “mission accomplished, crisis over”, but partly also to return markets to an independent existence from which central banks can once again derive useful information.

But in order to take the debate from within their own councils, and bring it out into the public domain, central banks will need to address three specific issues, and create a coherent narrative for all three.

First, they will need to be able to answer the line that “In the good old days (i.e. pre-2007, pre-2000, pre-1986, pre-1970 – pick the period and rose-tinted spectacles of your choice) life was good, economies worked and central banks had small balance sheets.  If we can only get back to small central bank balance sheets then the good life and prosperous economies will return”.

This is simplistic, and it should be easy to rebut – it confuses coincidence and causality, and ignores all the other changes since QE was brought in, not least the effect that very low interest rates have had on the interaction between bank reserves and interest rate policy.  But it is so seductive an argument that central bankers cannot assume that it will not need their careful attention.

Second, they will need to have a coherent theory for whether the impact of the central bank balance sheet on an economy is predominantly a stock matter or a flow matter. Is it the fact of having a large balance sheet that matters, or is it the act of growing it?  And at the end of QE, is the return to normality when the central bank balance sheet stops growing, or when it shrinks back to some predetermined and smaller size?  (And if so, what size?)

In short, what does the end of QE look like, even in theory?  Central bankers have been asked for a definitive answer to this for over five years, and have never once produced a convincing one. The implication is that central bankers themselves have not yet agreed among themselves on the answer, either to this or to the related question of how the size of their balance sheet impacts other market participants. But they cannot hope to win any support from the politicians or the public for any proposed course of action until they can publicly display a consistent and coherent analysis of the issues.

And third, if central bankers decide that their balance sheets should shrink, they will need to both have and then articulate to the public a very clear idea of how to do it, how fast to do it, how far they intend to pursue it and what the responses of the economy and markets are likely to be as they do so.  Until they do, it would be reckless to start the process – they could cause real damage to all three of the economy, the markets and not least their own reputation if the process goes wrong. [...]

Recently, though, some central bankers have started to try to open the dialogue on balance sheet size.  A thoughtful speech by Lael Brainard, a member of the Fed’s Board of Governors, at the start of the month accepted that the issue needs discussion and suggested that interest rate levels and balance sheet size were independent of each other – in other words, either could be used independently of the other when the economy needed stimulus to be added or withdrawn. [...]

Full speech

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